Going Into Earnings, Is Alphabet Stock a Buy, Sell, or Fairly Valued?

Alphabet (GOOGL) stock is up 44% over the last twelve months. Ahead of the company’s third-quarter earnings report , here’s Morningstar’s take on what to look for in Alphabet’s earnings, as well as the outlook for the stock.

Key Morningstar Metrics for Alphabet

• Fair Value Estimate: $161.00
• Morningstar Rating: 4 stars
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

Alphabet’s Earnings Date

Oct. 24, after the close of trading.

What to Watch for In Alphabet’s Q3 Earnings

• We would focus mostly on advertising revenue growth in Search and YouTube.
  • For Search, we’d like to see whether the continuing macro uncertainty is impacting advertisers. We have assumed growth will continue in the second half of this year.
  • We still do not expect a material impact from Microsoft’s MSFT ChatGPT-powered Bing on Google Search this year. We’d like to hear whether Search is feeling any pressure from Bing or other search offerings powered by artificial intelligence.
  • We’d like the firm to provide more color regarding Bard and the Search Generative Experience, and where the usage of each stands when compared with regular Google Search.
  • Regarding YouTube, we expect continuing top-line growth, to be driven mainly by direct response ads. We’ll also look for more color about contributions from broad-based campaigns, which could be an indicator of advertisers’ sentiment about the economy for the rest of the year.
• In terms of the cloud segment, we will be focusing on profitability, as well as how much generative AI may have contributed to the top line.
• We also expect color regarding how much additional capital expenditure is needed going forward to accommodate the increased training and inference AI requires.
• Regarding the overall bottom line, we’d like to have a better sense of the firm’s traffic acquisition costs, whether they will be increasing significantly as the firm likely renegotiates with Apple AAPL and/or Samsung, and to what extent the current search antitrust case against Alphabet is impacting the negotiations. Most of Apple’s testimonies in the trial have helped Alphabet, in our view.
• Overall, our long-term view hasn’t changed, and we continue to view the stock as attractive.

Fair Value Estimate for Alphabet

With its 4-star rating, we believe Alphabet’s stock is undervalued compared with our long-term fair value estimate.

Our fair value estimate is $161.00 per share, equivalent to a 2024 enterprise value/EBITDA ratio of 17. We expect margin pressure in 2023, given the firm’s aggressive hiring in 2022, continued investments in growth initiatives, and the slight short-term impact of Bing and generative AI. We look for margin improvement in 2024-27, driven by better generative AI search monetization and faster growth in the cloud, driven by wider adoption of generative AI. Our model assumes a five-year compound annual growth rate of nearly 11% for total revenue and a five-year average operating margin of 24%.

We expect advertising revenue to remain over 70% of Alphabet’s total revenue, driven by continuing growth in overall digital ad spending, albeit at a much slower rate than it’s historically had. We model nearly 6% ad revenue growth for 2023 due to economic uncertainty. We have estimated total Google ad revenue of $233 billion in 2023 and $247 billion in 2024. We think YouTube will contribute about 13% of Google’s advertising revenue in 2023, similar to 2022, and 14% in 2024. YouTube growth should benefit from its impressive reach and usage frequency, plus its video-only content format, which is attractive to advertisers.

We believe the company will continue to gain traction in the cloud market, with 23% annual revenue growth through 2027.

Read more about Alphabet’s fair value estimate.

Alphabet Historical Price/Fair Value Ratio

Ratios over 1.00 indicate when the stock is overvalued, while ratios below 1.00 mean the stock is undervalued.

Economic Moat Rating

We assign Alphabet a wide moat, thanks to durable competitive advantages derived from its intangible assets, as well as its network effect.

We believe Alphabet holds significant intangible assets related to overall technological expertise in search algorithms and artificial intelligence (machine learning and deep learning), as well as access to and accumulation of data deemed valuable to advertisers. We also believe Google’s brand is a significant asset. “Google it” has become eponymous with searching, and regardless of actual technological competency, the firm’s search engine is perceived as being the most advanced in the industry. While Bing is attempting to dethrone Google with AI technology from OpenAI, we think the firm can defend its dominance in search with its own AI technology, some of which OpenAI’s products are based on.

In our opinion, Alphabet’s network effects are derived mainly from its Google products, such as Search, Android, Maps, Gmail, YouTube, and more. Ultimately, we view Google’s network as heterogeneous. On the one side, all the products Google offers have provided it with a massive consumer base that allows the company to collect data. On the other side, via its rich collection of data and large user base, Google can offer the best return on investment for advertisers and build a growing network of advertising customers. The addition of each new ad and advertiser improves the efficiency of Google’s programmatic advertising offerings, allowing the firm to better monetize the network.

Google Search’s large and growing user base has created a network that’s difficult to replicate, in our view. We believe each additional search on Google’s engine creates value for other users, as well as for advertisers and businesses. With AI technology, more requests made by current and/or new users improve the relevancy of search results, creating value for users. More relevant results also decrease the likelihood of users jumping to another search engine, creating somewhat of a barrier to exit.

Read more about insert company’s moat rating.

Risk and Uncertainty

Our Morningstar Uncertainty Rating for Alphabet is High, primarily the result of its high dependency on continuing online advertising growth. While we remain confident that Google will maintain its dominant position in the search market, a long-lasting downturn in online ad spending could have a negative impact on Alphabet’s revenue and cash flow, resulting in a lower fair value estimate. On the other hand, positive returns on Alphabet’s investments in cloud and moonshots could increase our fair value estimate considerably.

Although its intangible assets and network effect will help Alphabet retain its competitive advantages, the minimal switching cost to utilize a rival search engine remains a risk for the company. This risk remains manageable, in our view, as Microsoft’s Bing—the nearest competitor and the first mover in enhancing search with generative AI capabilities—currently does not have a significant presence in the mobile market, which is one of the main growth drivers of the search ad market. Google also has generative AI technology to defend its global search market share of over 90%.

Read more about insert company’s risk and uncertainty.

GOOGL Bulls Say

• As the number of online users and usage increase, so will digital ad spending, of which Alphabet will remain one of the main beneficiaries.
• Android’s dominant global market share of smartphones leaves Alphabet well-positioned to continue generating top-line growth as search traffic shifts from desktop to mobile.
• The significant cash generated by Google Search allows Alphabet to remain focused on innovation and the long-term growth opportunities new areas present.

GOOGL Bears Say

• There is little revenue diversification within Alphabet, as it remains heavily dependent on Google and the state of the search ad space.
• Alphabet is allocating too much capital toward high-risk bets, which have a very low probability of generating returns.
• Google’s dominant position in online search is not maintainable, as more companies and regulatory agencies are contesting the methods through which the company has been extending its leadership.

This article was compiled by Adrian Teague.